Commentaries (some of them cheeky or provocative) on economic topics by Ralph Musgrave. This site is dedicated to Abba Lerner. I disagree with several claims made by Lerner, and made by his intellectual descendants, that is advocates of Modern Monetary Theory (MMT). But I regard MMT on balance as being a breath of fresh air for economics.

Saturday, 8 October 2016

Are interest rates artificially low?

Summary. Contrary to popular perception, rates are not artificially low because of central banks’ low interest rate policies of recent years. The reality is that rates were artificially BOOSTED by central banks in the years prior to the crisis. On the other hand there are other factors which interfere with the free market rate of interest and the net effect of all those factors is near impossible to determine. The other factors are fractional reserve banking, which artificially reduces the rate, and government borrowing which artificially raises interest rates in all probability.

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When a big change occurs, it’s normal to assume there must be something odd or artificial about the new order, i.e. that the old order represented the NATURAL state of affairs. Thus people tend to assume there must be something ARTIFICIAL about the low interest rates of recent years. I.e. it’s commonly assumed, that the free market rate of interest must be above its current level.

Prof Stephanie Kelton (a leading MMTer) hinted at the flaw in that idea in these tweets recently.

Yellen was asked about Trump's accusation that the Fed is keeping rates "artificially low" in order to influence the election.

So in what scenario would a genuine free market rate of interest obtain? Let’s answer that by starting with the simplest possible economy, and then add the complexities of the real world. (Incidentally I’m not suggesting Kelton would necessarily agree with the paragraphs below)

Assume the following:

1. A barter economy where the people democratically vote to create a form of money with a view to circumventing the inefficiencies of barter.

2. The new form of money will be issued by a newly formed “central bank” (CB).

3. Initially the only form of money is CB issued money (i.e. base money). That is, money creation by private banks is not allowed: in fact there ARE NO private banks – everyone just has an account at the CB (an innovation that CBs are actively considering right now, as it happens). As to whether the base money takes the form of some rare metal like gold or comes in fiat form doesn’t matter.

4. As to lending and borrowing, that takes place direct person to person (or person to firm etc) rather than via commercial banks.

5. There is no government borrowing.

Now what’s the optimum amount of money to issue? Well the larger each person’s stock of money, the more they’ll tend to spend all else equal. So as the stock of money rises, demand rises. And it will rise to the point where inflation becomes excessive. So the optimum amount of money to issue is the amount that induces the population to spend at a rate that maximises employment while keeping inflation at acceptable levels (NAIRU if you like).

As to the rate of interest, obviously that will settle down to some genuine free market level as long as the CB does not deliberately interfere with it – or in the words of Kelton, as long as the CB does not offer interest on reserves (IOR). (Reserves are not held by INDIVIDUAL PEOPLE in the real world of course, but in our hypothetical economy, since individual people have accounts at the CB, that money amounts to reserves.)

Notice that demand is regulated in our economy by a mix of fiscal and monetary means: i.e. given inadequate demand, government just creates more base money and spends it into the economy (and/or cuts taxes). That spending falls into the “fiscal” category, while the resulting rise in the stock of money falls into the “monetary” category. That is, demand is not regulated by adjusting interest rates.

How about interest rate adjustments?

But suppose it was decided that adjusting interest rates was a good idea, how would government and CB do it? Well the only way of artificially cutting rates would be for the CB to offer cut price loans to all and sundry. But that would involve the CB engaging in COMMERCE, i.e. that would involve exposing the CB to the possibility of losing money. And that in all probability wouldn’t be acceptable in the hypothetical economy just as it is regarded with suspicion in the real world.

So an alternative would be for government to spend an EXCESSIVE amount of money into the economy, and then, with a view to damping down demand, artificially raise interest rates by offering interest on reserves. Alternatively government could borrow by issuing bonds. But that would quite clearly result in an artificially high rate of interest.

Having issued that excess stock of money, the CB is then in a position to adjust interest rates by for example altering interest on reserves.

And that, lo and behold, is what happens in the real world, as intimated in Stephanie Kelton’s tweets.

To summarise, if demand is going to be adjusted by altering interest rates, interest rates have to be maintained at an above free market level – at least in our simple hypothetical economy. So the next question is: does that also apply to the real world once we’ve added the complexities of the real world?

Government borrows.

With a view to making our economy more realistic, let’s now assume that government borrows so as to fund infrastructure investments etc rather than to artificially raise interest rates.

Does that infrastructure borrowing artificially raise rates? Well it’s hard to say because it’s not clear whether government ought to borrow for that purpose or not.

Certainly the conventional wisdom is that the latter borrowing is justified. On the other hand Milton Friedman advocated a zero government borrowing regime as does Warren Mosler. I also set out several of the flaws in the latter conventional idea here.

(For Friedman, see his American Economic Review paper "A monetary and fiscal framework…”, para starting “Under the proposal…”. For Mosler, see his Huffington article “Proposals for the banking system”, 2nd last paragraph.)

At any rate, if infrastructure borrowing is NOT JUSTIFIED then by definition, the effect of government borrowing will be to artificially raise interest rates.

Alternatively, if such borrow IS JUSTIFIED, then the effect of government borrowing will be to artificially raise interest rates.

Fractional reserve banking.

Having said that in the hypothetical economy private banks are not allowed, what happens if they ARE allowed? Well fractional reserve banking tends to reduce interest rates and for reasons set out by Joseph Huber in his work “Creating New Money”. See passage starting “Allowing banks to create new money…”

Conclusion.

In order to use interest rates to adjust demand, interest rates first have to be artificially raised, which is a flaw in the whole interest rate adjusting idea. However there are other factors which interfere or may interfere with the rate of interest, in particular fractional reserve banking and government borrowing. As to what the overall or net effect of all those factors is, well that’s hard to say.

Non-peer reviewed (or only lightly peer reviewed) publications. The coloured clickable links below are EITHER the title of the work, OR a very short summary (where I think a short summary conveys more than the title).

i) The above is not a complete list in that earlier versions of some papers have been omitted. For a more complete list see here, and “browse by author” (top of left hand column).

ii) 7 deals with a wide range of alleged reasons for government borrowing, including Keynsian borrow and spend. 6 is an updated version of the "anti-Keynes" arguments in 7. 5 is an updated version of 1, which in turn is an updated version of 4.

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Bits and bobs.

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1946 article by the chairman of the New York Fed arguing that taxes are irrelevant. He overstates his case a bit. But’s an interesting bit of history all the same.________EU owes Britain £9.3bn.________

Imbecile at the top of the IMF, Olivier Blanchard, says he isn't sure how to deal with a recession should one hit next year. But that’s hardly news. As Bill Mitchell has pointed out over and over, the IMF and OECD are staffed by incompetents.________

I suggest it’s simply the fact that recent high unemployment has caused employees to be cautious about wage demands for the moment. Same effect apparent after WWII? I.e. the inflation / unemployment relationship was better in the 1950s and 60s than in the 70s and 80s: caused by the fact that employees in the 50s and 60s had memories of the 1930s?________

You want interest on the money you deposit at your bank? Then you want to be a money lender.

Fine: I admire people who to enter the world of commerce. But what on Earth makes you think there’s an obligation on taxpayers to rescue you if your little commercial venture goes wrong? Taxpayers don’t rescue those who put money into the stock exchange or who start small businesses if those go wrong.

Everyone has a right to a totally safe bank account which earns no interest. They DO NOT have a right to enter commerce in the form of having someone lend out their money and expect the taxpayer to rescue them if that does wrong.

J.P.Morgan fined billions for fraud. They pay the fine with money made from another fraud.________

The idea that accounts should be available to all at the central bank has a good pedigree: James Tobin advocated the idea in 1987 – p.172. ________

Contrary to claims by Stephanie Kelton, significant spare plant capacity does not prove the economy has spare capacity. Reason is that upping plant utilization requires more labour, and if employers cannot find suitable skilled labour, then there just ain’t any spare capacity. Put another way, what an economy runs short of as it approaches full employment of labour is . . . wait for it . . . labour!________

The golden rule of UK housing is that house owners are more likely to vote than non-owners, thus it’s important for every political party to suck up to house owners and make sure house prices keep rising. The result is that over the last 20 years house prices in the UK have doubled in real terms, while in Germany they’ve remained constant in real terms. Other countries could learn from British idiocy / wisdom (take your pick).________

Extra £10bn for Help to Buy housing subsidy results in main housebuilder shares rising by £1bn. Hope that helps you understand “trickle down”….:-)________

You deposit money in a one year term account at a bank: taxpayers insulate you against loss. You deposit money at a non-bank corporation by buying its one year bonds (which are the same thing as a one year term account) and taxpayers DON’T insulate you against loss. I don’t expect apologists for the existing bank system to explain this anomaly. There IS NO explanation for the anomaly. Conclusion: it is not the job of taxpayers to insulate money lenders against loss.________

Simon Wren-Lewis questions the validity of MMT. I left a comment, but it normally takes him a day or two to get round to publishing comments. ________

As long as government is willing to “insure” deposits of banks that speculate in this manner, it creates an obvious condition of “heads managers win” and “tails shareholders and taxpayers lose.” - Christopher Whalen.________

Regulators don’t know how to control banks, but racoons do....:-)________

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MUSGRAVE'S LAW SOLVES THE FOLLOWING PROBLEM.

The problem. Deficits and / or national debts allegedly need reducing. The conventional wisdom is that they are reduced by raising taxes and / or cutting government spending, which in turn produces the money with which to repay the debt. But raised taxes or spending cuts destroy jobs: exactly what we don’t want. A quandary.

The solution. The national debt can be reduced at any speed and without austerity as follows. Buy the debt back, obtaining the necessary funds from two sources: A, printing money, and B, increasing tax and/or reduced government spending. A is inflationary and B is deflationary. A and B can be altered to give almost any outcome desired. For example for a faster rate of buy back, apply more of A and B. Or for more deflation while buying back, apply more of B relative to A